Five Reasons NOT to Form Your Startup As an LLC
There are plenty of savvy startup experts who will tell you that there is absolutely no reason to form your startup as an LLC. You should always be a Delaware C Corporation.
If you talk to any of the major accelerators, that’s what they’ll tell you. Same for most VCs.
But make no mistake, there are plenty of reasons to form your startup as an LLC. After all, forming your business as a Delaware C Corporation isn’t for your benefit; it’s for your investors’ benefit. In the short run, it’ll cost your business time and money. If your business is making less than a million dollars a year, you’re probably going to give more money to Uncle Sam as a C corporation than as an LLC. Plus, there’s the $300 or more you have to pay in annual Delaware franchise taxes. And then you have to hire a registered agent in Delaware. And you’re going to need additional formation documents. And you’ll have to stick with corporate governance year after year.
So yeah, there are plenty of reasons why SOME startups shouldn’t be Delaware C Corporations.
If you’re a single founder who is looking to fund the business through Kickstarter, an LLC is almost certainly the best form for you. If you’re opening a bakery or coffeeshop or brewery, an LLC should be just fine. If you’re a tech startup with modest funding and growth expectations, an LLC could work there, too.
But still, even with the downsides in mind, there are still many reasons why you should categorically NOT form your business as an LLC. Here are just a few:
Reason 1: You’re looking to join an accelerator
As I mentioned earlier, accelerators want you to be a Delaware C Corporation. For most of them, this isn’t up for debate. If you want to join TechStars, Y Combinator, Founders Institute, BoomTown, or any of the other major accelerators, being an LLC is a non-starter.
So you might as well start as a Delaware C Corporation.
Reason 2: You want to signal to VCs that you’re ready for investment
The landscape for startup investment is competitive.
Most VCs can’t invest in LLCs. So if you’re trying to let VCs know you’re ready for investment right away, you should probably give them want they want right away.
If you’re truly a unicorn in the making, VCs will still give you money and just tell you to hire good lawyers to fix your documents. But if you’re a marginal company looking to raise capital, forming as an LLC is a way of telling investors, “I’m dipping my toes in the startup pool. Not sure I want to spend $2000 to form my business right just yet, though. But if you give me a couple of million dollars, I’ll do whatever you want!”
Good luck with that. It’s a way of saying you’re not serious about being a serious growth company. That’s a bad signal to give your potential investors. In a competitive investment environment, that could be the difference between getting funding and not getting funding.
Reason 3: You’re looking to raise multiple rounds of funding
In terms of most business documents, you can do most things with an LLC that you can do with a corporation – and there’s even some things you can do with an LLC that you can’t with a corporation. But if you’re looking to set up a multi-tiered structure with multiple rounds of investments in an LLC, expect it to cost at least 5x more with an LLC than it would have with a corporation.
And there’s a high degree of probability even then that there will be issues. Because there are different laws that apply to LLCs as opposed to corporations. And depending on the state you live in, these laws have been around for 100-200 years less than corporate laws have. So courts and lawyers are still figuring things out with these types of entities.
That creates considerable uncertainty for any company with a complex structure.
Reason 4: You want to give equity not just to the original founders, but to later employees, too
The process for issuing equity to founders is simple for LLCs and corporations. For corporations, it’s still simple even after you raise capital. You authorize stock options and then grant them to future employees.
For LLCs, it’s not so simple. Have you ever heard of a profits interest grant? Has your accountant ever heard of a profits interest grant? Again, if you’re an LLC, expect to pay a lot more to do this with an LLC than with a corporation.
All of this brings us to our last point, which is…
Reason 5: Partnership taxation is actually super complex
Partnership taxation, the default tax classification for multi-member LLCs, is actually super complex. As in, so complex that more than 90% of attorneys and accountants get it wrong.
Most people start LLCs because, “they’re simple.” And sometimes that’s true, and sometimes it’s not. If you’re a simple bakery or single-member LLC, then yeah, an LLC will probably end up being pretty simple for you. And if you’re a private equity company, you’ll have the resources to exploit an LLC to the fullest extent of its tax advantages. The trouble comes in with those who fall into the middle category – the ones that are kind of complex and “don’t know what they don’t know.”
For these companies, LLCs aren’t actually that simple. And they only realize that fact after they’ve gotten in way over their head.